The US dollar’s rally against global currencies, including the Indian rupee, since mid-April, couldn’t have come at a better time for those Indian firms stuck with a cross-currency derivative mess, say some analysts and bank executives who sold the exotic derivatives to their clients.
The greenback’s rise presents an opportunity for some of the firms to square off on their positions. A good number of the misfired bets on currency derivatives placed by Indian firms were on the price relations between the Swiss franc and the US dollar and that of Japanese yen–US dollar.
Derivatives are contracts whose value is derived from another price. A currency derivative derives its value from the price of the currencies on which it is based. A move in the underlying price usually leads to a change in the price of the derivatives based on it.
While the US dollar has risen some 6.94% against the rupee since 17 April, it has appreciated 7.66% against the Swiss franc and 7.39% against the Japanese yen during the same period, according to Bloomberg data.
“Some customers now want to exit their derivative contracts,” claims Partha Mukherjee, head of treasury, Axis Bank Ltd. “We have certainly seen some recovery in dollar but (I am) not sure whether this is conclusive or permanent,” said Mukherjee. In marginal cases, a “lot of customers” are being advised “to get out while the going is good”.
However, some bank executives say they are in a dilemma, whether to advise their clients to cut out derivative positions now. The clients could also be in a similar fix.
That is because, in most cases, the firms will still be booking losses if they exit now. In that case, what is notional (mark-to-market) now, will get crystallized. However, the upside of exiting could be that the losses might be a lot lower than what these companies were earlier estimating. And, if the dollar rally continues, the losses could further narrow.
“Instead of advising clients to exit, we are presenting them facts and fundamentals,” says the head of treasury at a large public sector bank, who sought anonymity to comply with the bank’s media policy. “It is for the clients (companies) to decide whether they want to cut (derivative) positions.”
As Mint and other newspapers have been reporting this year, many firms are battling their bankers in court, alleging that bank officials had mis-sold these financial instruments without informing them about the risks attached to such instruments. Most derivative deals were signed off by firms to hedge business risks associated with currency price fluctuations.
A hedge is an investment carried out to negate or minimize risk associated with another investment. Hedging essentially is not a trading mechanism, therefore profit or loss from the activity is meaningless.
A.V. Rajwade, an independent foreign exchange dealer and a consultant to several firms on derivatives, insists that most of these exotic derivatives were speculative and in violation of Fema (Foreign Exchange Management Act) regulations and banks misled their clients to these deals. “That’s why the court cases are going on,” he said. “If the positions are speculative in nature, and thus a contravention of regulations, it is a reasonable time to unwind such positions.” The cross-currency bets began following a sharp rise in the rupee after April 2007, a move that corroded the profits of many small and big exporters. To protect their earnings, exporters chose to hedge on exotic foreign exchange derivatives.
Traditionally, Swiss franc and Japanese yen were considered as stable currencies against the dollar. The Swiss franc was trading at 1.2073 against a dollar on 30 April 2007 and, on 31 August, it was at 1.2085 against the dollar. The yen on the two days was 119.52 and 115.78.
While many global economists had predicted doom for the dollar in the long run, financial markets and many investors, including some Indian firms—which had bet on such exotic instruments—appeared to have been bullish on the dollar’s future value. However, the mortgage and credit crisis that struck global markets in August led to global currencies, bonds and equities moving in unexpected directions.
In December 2007, the Swiss franc strengthened to 1.1335 and yen shot up to 111.71. By around 31 March, the franc was 0.9931 a dollar while the yen was 99.69 a dollar.
As a result, the failed bets resulted in several Indian companies facing mark-to-market losses bigger than their annual revenues. The Institute of Chartered Accountants of India (Icai) has since asked its members to ensure that the client firms they audit report mark-to-market losses for potential derivative losses.
Early this year, many such firms, including Rajshree Sugars and Chemicals Ltd, Precot Meridian Ltd, NCS Sugars Ltd, Sundaram Multi Pap Ltd and many others, took on the banks, including ICICI Bank Ltd, Yes Bank Ltd, Kotak Mahindra Bank Ltd and Axis Bank, which sold them the contracts, through lawsuits. Some foreign banks including Citibank and Standard Chartered Bank, were also made parties to some suits.
Most firms alleged that they were sold products that were beyond their requirements of hedging and were complex exotic derivatives products. Most of the suits are still ongoing.
J. Moses Harding, head of the wholesale banking group at IndusInd Bank Ltd notes that companies can book profits or losses at any point and they are not bound to carry on with the contract.
For those firms that had bet on the dollar’s strength the knock-in damage has “already been done”, he said. A company’s cash flow would determine “how big a hit they are ready to take”, by exiting.
A knock-in is an option that comes into effect when a certain price range is met. If the price is never reached, the contract is not exercisable.
When the contract is exercisable and the company’s bet goes wrong against that of the bank, the loser has to buy dollars from the bank at a much higher pre-fixed rate than the prevailing market rate.
On the contrary, if the bank’s bet goes wrong it will pay its customer some pre-agreed amount. A senior executive of a firm involved in an ongoing court case with its bank over derivatives, says he is not sure if many firms will want to exit its derivative contracts with losses. “I don’t really think companies can wipe off too much of their losses,” he said.